It is tempting to see the euro as an opportunity for custodians to consolidate their processes for euro-zone investors and significantly simplify their euro-zone operations. However, it is important to remember that although EMU, and the introduction of the single currency in particular, will bring the 11 participating countries closer together in many ways, there are certain fundamentals that affect custodians and investors alike, that will not be readily overcome.
Although all trades will be settled in euros, different settlement procedures and exchanges will remain, affecting costs, settlement times and settlement rates in the markets.
Markets such as Luxembourg and Dublin will remain more popular with certain investors due to favourable regulations (eg. taxation); and each market will continue to have different accounting standards, regulatory re-porting requirements and specific in-terpretations of European directives.
Custodians will therefore need to maintain flexibility in settlement and reporting for years to come, whilst having a system which will allow its processes to converge as the markets do so.
Making the required systems changes for handling the euro has been expensive and time consuming for custodians. That said, it has been an essential task for them, unlike those investment administration providers that have only made changes to facilitate other aspects of their business.
As a result, an observable trend is for organisations that undertake investment administration in-house to outsource it to a custodian (such as pension funds). Reasons for this include the trend to outsourcing in-house asset management, not being able to make the internal systems changes required for euro, (such as providing reporting in both legacy currencies and euro) and the likelihood, in the longer term, of the size of domestic assets not justifying the service (as assets gradually move from domestic to euro-zone investments).
There are other investment changes resulting from the euro that will make the appointment of a custodian more attractive or necessary for investors. In particular, as asset managers diversify their investments (to enhance re-turns) by both instrument type and market, the accounting, performance measurement and compliance monitoring reporting capabilities of a custodian will provide a superior picture of the fund. Also, with increases in the number of portfolios (such as with the appointment of specialist managers), the need for consolidated reporting from a custodian will intensify.
Existing custody clients will also benefit from changes made as a result of the euro. Examples of services, which may be enhanced or may start to be utilised are discussed below:
With the predicted change from market to industry focus, many in-vestment managers are expected to also change performance benchmarks. Custodians will be able to provide performance reports using the new benchmarks (of which there are many) and information relating to the changes in asset allocation.
Over the next few years, investment managers and the industry as a whole will determine the benchmarks that include the most appropriate markets and number of stocks. At a later date custodians should be prepared to provide historical performance (back to January 1 1999) if a client moves to this standard.
Changes in market exposure, diversification of investments and expected new issuers of securities are likely to affect the risk profiles of investors. In order to understand and manage this risk, investors should have their custodian test the compliance and exposure of their portfolios. Some custodians will need to enhance their compliance monitoring services in order to provide the tests that will be most compatible with the changes in in-vestment structure.
Although some custodians do al-ready offset between cash accounts in different currencies for balances in credit and debit, the euro will make this more likely between the euro-zone markets, with one rate paid for the sum of all cash in these markets. The resulting rate may not be as high as currently offered in some markets, but will be better than the current 0% in others.
Longer term, the revenue available from cash management is likely to drop as the market moves to a nearly flat yield curve. Nevertheless, costs for the service should reduce when the majority of assets are in one currency.
The most obvious impacts of the euro on foreign exchange are the elimination of currency risk within the euro-zone. This should result in cost reductions for clients and revenue reductions for the custodian. Nevertheless, custodians will need to provide this service notionally for the period of time their clients wish to receive reports in legacy currencies. Whenever trades are settled, there will need to be a notional conversion from the legacy currency to euro (of course with no charge).
Corporate consolidation is expected to escalate across the euro-zone be-cause of the single currency. As a re-sult, investors are likely to place im-portance on the reporting and managing capabilities of custodians with respect to corporate actions. In addition, the expected increase in new issuers of securities and diversification into small cap stocks, will increase the volume of corporate actions to be monitored and advised to clients.
Unlike government bonds, which will mostly redenominate at the beginning of the transition period and then in batches, securities will be redenominated over the three year period at the issuer's discretion. This redenomination can be thought of as a corporate event and custodians will be responsible for being aware of and properly converting the securities at the correct time.
It is unlikely that tax claims will be accepted in euro, at least initially in some markets. Custodians will therefore need systems that handle dual currency tax reclaims. In the longer term, whether or not the tax reclamation services offered by custodians will be simplified with the euro is open for debate (at the time of writing, the po-tential consolidation of tax regulations is being discussed at many levels). If, as predicted, there is a gradual sale of domestic securities to purchase euro-zone securities, there will be a slight increase in the realisation of capital gains tax. Custodians must be able to handle and report on this.
With the move to diversified investments, increasing numbers of invest-ors are likely to use derivatives. Custodians' reports on portfolio exposure after derivatives and their processing experience with derivatives will be invaluable.
Unit accounting / fees
Although not a direct consequence of the euro, it is predicted that European pension funds will grow significantly and be designed as defined contribution funds, possibly offering member investment choice and covering multiple jurisdictions. Custodians have a role in assisting the administrators of these plans via unit accounting services.
One aspect of the custodian's operation of perennial interest to its clients is fees. Whilst it is likely that the euro will lead to reductions in fees, the im-pact may not be immediate. Many factors will contribute to the reduction, such as increased market-size, competition and improved efficiency and technology but their actual contribution will only be realised over time.
While the settlement process cannot be completely consolidated across the 11 markets, there will be settlement efficiencies due to the euro. These should lead to lower transaction fees particularly if systems developments for the euro have led to technological advances. Lower fees may also result from increased volume of trades (from greater liquidity and the euro-zone being more attractive to all investors worldwide).
However, if the market is more attractive to investors, then the value of securities will rise, which will actually lead to an increase in fees payable as these are charged in basis points (for example, safekeeping fees for all custodians and reporting fees from some custodians).
A trend is emerging for one fee for all euro-zone countries, even though exchanges will continue to operate in each country. The final level of this euro-zone fee will be of interest to the whole financial industry.
The continuing trend for mergers and acquisitions within the financial industry, and certainly the custody industry, is a hot topic for discussion. The euro presents custodians with another challenge: the cost and changes required to become euro compliant will be yet another factor in custodians' long term survival.
This also applies to the markets themselves. Trading will move away from those exchanges that remain more expensive and/or inefficient, possibly resulting in closures. Custodians based in such markets are un-likely to survive if this happens.
For these and many other reasons, custodians are likely to move to providing a euro-zone service, instead of a domestic one. The recent trend of mergers, acquisitions and strategic alliances is likely to continue over the next few years as custodians strive to achieve a pan-European capability. Through alliances (in whatever form) custodians will be better aware of differences between markets and the impact on their services.
In conclusion, there are many changes predicted for the financial industry as a result of the euro. Many of these are evolutionary and not expected until at least the medium term. Nevertheless, as long as custodians have prepared properly in terms of systems and service enhancements, the euro should be a positive experience for them and their clients.
Suzanne Findlay is an associate in Towers Perrin's Global Custody Consulting Services practice in London.